Risk and Reward

Risk and Reward

Unless you are very new to investing, you have probably heard of the term, Risk/Reward Ratio, but I wonder how many of you are familiar with the calculation used to determine what the Risk/Reward Ratio of a particular investment is. Of course there is a calculation; nearly everything about Wall Street is a calculated risk. That may surprise you because, quite often, investing sounds like a close cousin to gambling, or if you are an insider to the industry; gambling with other people’s money.

The calculation is not a terribly difficult one. You just take the amount of profit you expect to make from a particular trade and divide it by the amount you could lose from that trade. The result is your risk/reward ratio.

Now while this calculation is better suited for the traders out there, every person needs to be aware of risk versus reward when it comes to your finances. So, does this mean I don’t have to think about risk and reward if I do not invest in the market?

Unfortunately we all need to think about risk and how it applies to our lives. Just because you’re not a professional race car driver doesn’t mean you don’t have to be aware of the dangers of getting behind the wheel.

So what are some of the risks we are subject to whether we are in the market or not? The first image that springs to mind is that of grandma kneeling before a mattress and hiding a stack of bills deep into the bedding. Just when I thought this method of savings was not practiced, we hear of this.

According to a story on CNN.com, In Tel Aviv, Israel, a woman gave her elderly mother a new mattress. It was a gift, and the daughter tossed out the old bed. Apparently the elderly mother was in the habit of storing her savings inside the old mattress; a savings to the tune of a million dollars. To me that seems a bit farfetched; a million dollars? Do the math. I did the math and discovered it would take no less than ten thousand, one hundred dollar bills to equal a million dollars. Can that many bills fit into a mattress? Wouldn’t you need something like a super extra, princess and the pea sized mattress or mattresses to fit the bill, so to speak?

But that’s not really the point here. The story hits home on several levels. Number one being that the world wide economy is so bad that hundreds upon hundreds were willing to suspend disbelief and show up in force at the city’s landfills in search of the magic mattress. Heck I even entertained the idea of hopping on board a plane…well, not really, but you get the point.

The other thing I want to point out regarding the mattress stuffing story is that apparently enough people do save money in this fashion that they totally believed that there was a mattress with at least some money hidden inside. It certainly made a good story for CNN as well.

So there you have it, a risk to mattress stuffers worldwide, make sure you don’t throw out your life savings with the mattress. The other big risk here would have to be fire, then theft.

The big one that most non market investors don’t think of enough is the money they are losing to inflation every year. The rate of inflation for the last ten years has been from 2.8% to as high as 3.8%, except where things stand in 2009 where we actually went negative. For all you mattress and cookie jar stuffers, you are hemorrhaging at the rate of 35,000/million stuffed, a year.

So the trick here is to find some investment vehicle that will not only keep up with inflation, but surpass it. You have to invest in a way that enables you to sleep at night. When just getting in the market it is easy to point out the guy that invests a million bucks and think, jeez that guy is taking a huge risk. Don’t be fooled here. It’s not about the dollar amount you invest, but about the percentage of your wealth that you risk.

If that million bucks only represents 5% of his capital, then he is not risking much. On the other hand the fella that invests ten thousand dollars, the only money he has, then he is taking a huge risk. You are the only one that knows how much risk you are able to live with.

If you are looking for growth stocks, and the thought of a twenty percent loss makes your blood run cold, then you need to reevaluate your portfolio, and your attitude about how much risk you can be comfortable with.

Your age has a lot to do with the amount of risk you are able to live with. As a young man in your late twenties or early thirties, you have many years of working life ahead of you so you can withstand more of a loss. If you take a big hit in a bad market, while it is painful, you have a good number of years working to make back that capital. You can afford to be somewhat aggressive.

Fast forward twenty years or so and the picture changes dramatically. If you take a huge loss at the age of 55 you may not have enough working years ahead of you to make back your losses. That is one reason why older investors turn towards fixed income. They are the same ones who scoffed at bond buyers when they were in their twenties. In fact, if you are in your twenties you may want to skip fixed income altogether in favor of getting a jump start on investing by sticking with equities.

At the end of the day, no one can determine how much risk is right for you. Your broker may have ten different formulas and twenty different reasons for you to buy something, but you are the only one that has to live with your choices. Remember, becoming a long term investor can go a long ways in reducing your market risk.

In the mean time, good luck and happy investing.